Following the onset of the 2008 financial crisis, a wave of restructurings was expected as deteriorating market conditions impacted the already stressed balance sheets of companies. The period of 2012-2015 was expected to be the peak for restructuring activity, as pre-crisis LBO and M&A debt (the so called “wall of debt”) came up to maturity. Instead, throughout the crisis years, restructuring and insolvency activity has remained generally low as central bank policies and open capital markets, particularly in the U.S., provided companies with easy and affordable access to capital.
Now, following the Federal Reserve decision in December 2015 to raise interest rates for the first time in eight years, it appears that it has embarked on the slow unwind of its zero–interest-rate policy. Against this backdrop we have also witnessed a reduction in quantitative easing in the U.S., a slowdown in China and increased geo-political tensions in the Middle East, which have resulted in a painful correction in world equity markets. In the UK alone, there has been a marked increase in profits warnings — 100 warnings were issued in Q4 2015, which is the highest quarterly total since 2009.
With restructuring activity already prevalent in the oil and gas sector and the commodities space in Europe, Africa, Asia and the Americas, the prevailing view is that the actions of governments and central banks during the crisis have not prevented the need for restructuring activity, but as mentioned above, have simply extended previous restructuring hotspots from 2012-2015 to 2018-2021. Therefore, as a number of deals reach their 2015 maturities and slowly evolve toward 2018 maturities, the less benign government economic policies and macroeconomic environment will increase the propensity for over-leveraged corporates to finally be forced into a substantive restructuring process
Recession Restructurings And the Role of the Central Banks
Restructuring and insolvency plays a vital role in the functioning of a healthy economy by removing market inefficiencies, forcing redeployments of capital and labour to more productive activities and, as a result, creating space and opportunities for new participants. However, following the 2008 financial crisis, the benign credit environment created by central bank actions, namely reducing interest rates to near zero, undertaking quantitative easing and providing financial bailouts, negated the need for many over-leveraged corporates to address their balance sheet positions, as they were able to refinance their debt in the low– interest-rate environment and continue to service their debt.
Non-performing companies were further aided by new bank capital regulations that encouraged banks to allow non-performing companies to refinance or amend and extend their debt, allowing banks to carry such debt on their balance sheets as performing assets rather than having to accelerate the debt and take balance-sheet write-downs. Further, where banks were not willing to refinance or amend and extend debt, distressed credit investors and, particularly, the high-yield market, gave companies access to credit and broke any log-jam in bank financing. The wall of debt was thereby scaled, but it was largely achieved by the recharacterisation of loans as performing assets or by substituted credit.
As a consequence, economies around the world have failed to clear the “deadwood” or “zombie” companies, which in previous recessions would have been restructured or forced into insolvency, resulting in inefficient allocations of resources. This may partly explain why the growth rate in U.S. output exiting the global financial crisis has been the lowest following any of the 11 post-World War II recessions.
A further unintended consequence of accommodative monetary policy during the financial crisis has been the growth in overseas borrowers and issuers accessing cheap U.S. dollar-denominated capital through the bank and bond markets, which has then been invested in higher yielding local assets in a form of corporate carry-trade. As monetary policy in the U.S. is unwound and interest rates rise, many of the corporates that have taken such funding, but failed to hedge against Foreign Exchange (FX) and interest-rate risks on their floating-rate debt are more likely to become distressed.
The Impact of Rising U.S. Interest Rates On Restructurings
According to a dot graph issued in December 2015, Fed officials expect the federal funds rate to be increased gradually with the rate being 1.375% at the end of 2016, 2.375% at the end of 2017 and 3.25% at the end of 2018.
The impact of such rises must be considered in both the short term, 2016-2017, and the medium term, 2018-2021 — the period during which the “new wall of debt” of approximately USD $1.2 trillion of low-interest rate speculative grade debt, which was refinanced between 2012 and 2015, comes up for maturity. In addition, distinctions must be drawn between the impact on U.S. companies and those overseas companies with U.S. dollar-denominated debt.
Short-Term Impacts: U.S. Companies
Anecdotally, while restructuring activity in the U.S. in Q1, 2016, has increased, it is still perceived to be unlikely to pick up significantly in most sectors in the short term. The commodity and oil and gas sectors are the one variable that will see rising levels of restructuring activity driven primarily by low commodity prices and macro and geo-political forces in these respective sectors rather than by interest rate rises. First, interest rate rises will only impact debt service costs on floating rate debt or any debt that comes up for maturity during this period, which is insignificant compared with the debt maturing in the medium term. Further, the interest rate of 2.375% expected by the end of 2017 is still low by historical standards and less than half of the interest rate in June 2007, which stood at 5.25%.
Short-Term Impacts: Overseas Companies
In contrast, restructuring activity can be expected to increase significantly in 2016 and 2017 for overseas companies, particularly in the emerging markets, most notably Brazil, India and Indonesia. While rising interest rates will, once again, only directly impact floating rate debt service costs in an insignificant manner, restructuring activity will be driven by worsening currency mismatch risk for corporations with local currency revenues, an insufficient hedging of FX and interest rate risks.
As U.S. interest rates increase, a repatriation of dollars into higher yielding U.S. investments will cause the U.S. dollar to continue its appreciation against foreign currencies, particularly against emerging market currencies, many of which have already been negatively impacted by the flight to safety following the recent collapse in commodity prices. This will increase the cost of servicing U.S. dollar-denominated debt in local currency terms, further stressing balance sheets and necessitating restructuring activity.
Brazil, India and Indonesia in particular are prime restructuring hotspots due to only approximately 50% of foreign currency debt in India being hedged, with similar rates of hedging in Brazil and Indonesia (some of the lowest rates of hedging globally). In fact, the impact of currency mismatch risk has already been seen in Indonesia, where PT Gajah Tunggal Tbk was downgraded with Moody’s citing, among other things, its “largely unmitigated exposure to a weakening Rupiah.”
In addition, as interest rates rise, China may prove to be an unexpected source of restructuring activity, particularly in the highly leveraged real-estate sector, where firms have issued approximately USD $63 billion of U.S. dollar-denominated debt, but have FX assets cover of less than 25%. Chinese firms have also been reluctant to hedge currency risks due to the pegging of the yuan to the U.S. dollar and the expectation that the cost of hedging (around 3.7% in December 2015) would be more costly than the protection provided. However, following recent devaluation of the yuan by the People’s Bank of China, debt service costs have increased significantly and it appears that further devaluation of the yuan will be allowed as the U.S. dollar strengthens further increasing local currency debt service costs and stressing the balance sheets of riskier lower-rated, highly leveraged Chinese firms.
These factors have led to concerns regarding the potential non-performing nature of Chinese loans. Current official data in China shows non-performing loans at 1.59% of outstanding credit (approximately RMB ¥1.2 trillion or USD $187 billion). However, if “Special Mention” loans are included, that brings the percentage of loans where repayment is at risk to 5.4% — low in historical comparison, but to put this into perspective, a 5.4% effective NPL rate is about RMB ¥4 trillion (or USD $628 billion). This equates to an amount slightly larger than the size of Sweden’s GDP, and more than twice the entire size of Greece’s economy.
Medium-Term Impacts: U.S. Companies
In the medium term, restructuring activity in the U.S. can be expected to accelerate rapidly as capital access and affordability declines due to rising interest rates and increased competition for capital.
First, as interest rates rise, high-yield investors will be less inclined to chase yield through lower-quality credit classes (a factor that allowed many speculative grade companies to refinance during the financial crisis) and instead will focus on less speculative grade companies that will provide sufficient yields for investors without the assumption of such significant default risk. This is likely to leave a whole class of the most speculative grade companies, which relied on high-yield financing to navigate the financial crisis, exposed to deeper and more substantive restructuring and insolvency risk.
Second, for those companies that have access to capital, the increased debt pricing due not only to rising interest rates but also increased competition for capital, will simply be too great for certain stressed balance sheets. As competition for capital increases, bank and bond investors will re-price insolvency risk spreads for lower-grade companies, which may overwhelm many balance sheets that are currently stressed even as debt service costs are at an all-time low.
Finally, the willingness and ability of creditors to amend and extend debt in the medium term will be reduced, removing a refinancing tool that played a vital role in the survival of many companies during the financial crisis. For banks, willingness to amend and extend debt terms relies on some future prospect of the full refinancing or repayment of the company’s debt. However, where companies have existed for eight years in the lowest interest rate environment in history and still failed to refinance or de-leverage, the prospect of future refinancing or repayment in a rising interest rate environment is questionable at best.
Further, the ability of CLOs to provide capital, which again played a significant role in extending debt maturities during the financial crisis, will have been reduced as the reinvestment period for approximately 69% of original CLOs will have ended. Any reduction in the issuance levels of the CLO primary market due to regulatory changes, such as risk retention rules, or otherwise will put upward pressure on loan spreads and reduce available capital for corporates, leading to the prospect of significantly higher leveraged loan default rates when refinancing needs arise.
Medium-Term Impacts: Overseas Companies
In the medium term, overseas companies with U.S. dollar-denominated debt will face the same credit access and pricing risks as U.S. companies and, in addition, will continue to face FX risks, which were described above. Further, where U.S. dollar-denominated funding is unavailable, local credit markets have insufficient depth to provide alternative local currency financing to refinance maturing U.S. dollar-denominated debt.
As a result, a wave of restructurings can be expected in the emerging markets, which will extend beyond those companies that are impacted in the short term, due to a lack of hedging, to all companies whose balance sheets are not sufficiently robust for a re-pricing of all of their maturing debt — or that simply lack access to capital due to local credit market depth.
One potential impact of this refinancing need in emerging markets, particularly China (where the credit (debt) to GDP ratio is expected to exceed 280% in the medium term), could be the nationalisation of corporate debt through the use of bailouts, as emerging markets seek to prevent a wave of restructurings.
The Growth Variable
One factor that could offset increased restructuring of U.S. dollar-denominated debt as U.S. interest rates rise is increased global growth. However, given the current malaise in China, Europe and Latin America, it is difficult to see where such growth will come from, absent a macro-economic shock such as war, which can provide short-term positive growth, or large changes in fiscal policy. The OECD figures support continued low growth expectations, with current predictions in global growth in 2016 and 2017 being 3.3% and 3.6% respectively (on the basis of 7% growth in China, which is looking increasingly unlikely given recent economic indicators).
Accommodative monetary policy during the financial crisis prevented the need for widespread restructurings in the early years of the financial crisis. However, the continuation of such policies for eight years has allowed a U.S. dollar debt mountain to form, which will drive an increase in restructuring activity as maturities evolve. As a result of the unwinding of accommodative policies, restructuring activity should be expected to rise slowly in 2016 and 2017 in the U.S. and more quickly overseas, before rapidly accelerating in 2018 onwards. While such restructuring activity will prove painful for the U.S. and world economy, it is a necessary evil to force efficient resource allocation and obtain increased growth rates, and to avoid a continuation of the low-growth malaise that is currently being seen in many countries around the world.
Originally published by LJN’s The Bankruptcy Strategist, April 2016